How to Treat Market Discount on a Tax Return

Handling market discount on a tax return can be a bit like navigating a maze if you’re not familiar with the rules. In essence, you treat market discount as ordinary income when you sell or dispose of the bond, up to the amount of the market discount. However, there are elections you can make to include the market discount in income annually, and special rules apply depending on the type of bond and whether it was acquired at original issue. Understanding these nuances is crucial for accurate tax reporting and potentially minimizing your tax liability.

Understanding Market Discount: The Basics

What is Market Discount?

Market discount arises when you purchase a bond for less than its face value (the amount the issuer will pay at maturity) in the secondary market. This discount occurs because factors like rising interest rates or concerns about the issuer’s creditworthiness make the bond less attractive to investors. The difference between your purchase price and the bond’s face value constitutes the market discount.

Is It Always Taxable?

Not necessarily. While the general rule is that market discount is taxed as ordinary income upon the bond’s sale or maturity, there are exceptions and elections that can change this. The key is to understand the specific characteristics of the bond and the choices available to you as the investor.

The General Rule: Ordinary Income Treatment

The default treatment is that when you sell, redeem, or otherwise dispose of a bond with market discount, the profit you realize, up to the amount of the accrued market discount, is taxed as ordinary income, not as a capital gain. Any profit exceeding the accrued market discount is then treated as a capital gain (short-term or long-term, depending on your holding period). This is important because ordinary income tax rates are often higher than capital gains tax rates.

Tax Treatment Options and Elections

The Default Method: Deferring the Income

Under the default method, you don’t recognize any income related to market discount until you sell or the bond matures. At that point, the accrued market discount is treated as ordinary income. This is the simplest approach but might not be the most tax-efficient for everyone.

Election to Include Market Discount Currently

Instead of deferring the income, you can elect to include the accrued market discount in your income each year. This election, made in the year you acquire the bond, applies to all market discount bonds you acquire that year and subsequent years. This approach can smooth out your tax liability over time, potentially avoiding a large ordinary income hit in a single year.

Accrual Methods for Market Discount

If you choose to include market discount currently, you must use either the straight-line method or the constant yield method to calculate the accrued amount.

• Straight-Line Method: This is the simpler method. You divide the total market discount by the number of days remaining until the bond’s maturity and then multiply that amount by the number of days you held the bond during the tax year.
• Constant Yield Method: This method takes into account the compounding effect of interest and is generally considered to be more accurate. However, it’s also more complex to calculate. You’ll need to consult IRS Publication 550, Investment Income and Expenses, for detailed instructions and calculations.

Partial Principal Payments

If you receive partial principal payments on a market discount bond, these payments are treated as ordinary income to the extent they represent accrued market discount. This reduces the amount of market discount that will be recognized later upon the bond’s sale or maturity.

Important Considerations

Identification is Key

Keeping accurate records of your bond purchases, including the purchase price, face value, and maturity date, is essential. This information is needed to determine the amount of market discount and to calculate the accrued amount.

Bonds Purchased at Original Issue

If you purchased a bond at its original issue and later acquired additional bonds of the same issue at a discount in the secondary market, the market discount rules still apply to the bonds purchased at a discount.

Tax-Exempt Bonds

The market discount rules generally don’t apply to tax-exempt bonds. However, if you dispose of a tax-exempt bond at a gain, a portion of that gain may be treated as ordinary income to the extent of the accrued market discount if the bond is not a qualified tax-exempt obligation.

Frequently Asked Questions (FAQs)

1. What is the difference between market discount and original issue discount (OID)?

Original Issue Discount (OID) occurs when a bond is initially issued at a price lower than its face value. Market discount occurs when a bond is purchased in the secondary market for less than its face value. The tax treatment of OID is different from market discount, generally requiring annual inclusion of the OID in income.

2. How do I make the election to include market discount currently?

You make the election by reporting the accrued market discount on your tax return for the year you acquired the bond. You must attach a statement to your tax return indicating that you are making the election under IRC Section 1278(b). This election is binding for all market discount bonds you acquire in that year and subsequent years.

3. Can I revoke the election to include market discount currently?

No, the election to include market discount currently is irrevocable unless you receive consent from the IRS to revoke it.

4. What happens if I gift a market discount bond?

When you gift a market discount bond, the donee (the person receiving the gift) inherits your basis in the bond, including the accrued market discount. The donee will be subject to the market discount rules when they sell or the bond matures.

5. How does market discount affect my state income taxes?

Generally, states follow the federal tax treatment of market discount. If market discount is taxed as ordinary income for federal purposes, it will likely be taxed as ordinary income for state purposes as well. However, it’s essential to check your state’s specific tax laws and regulations.

6. What if I sell a market discount bond at a loss?

If you sell a market discount bond at a loss, the loss is treated as a capital loss. The market discount rules do not convert a capital loss into ordinary income. However, the accrued market discount that has not yet been included in income is still treated as ordinary income upon the sale, up to the amount of the realized gain.

7. How do I report market discount on my tax return?

You report market discount on Schedule B, Interest and Ordinary Dividends, of Form 1040. The accrued market discount is reported as ordinary income. If you sold or redeemed the bond, you’ll also report the sale on Schedule D, Capital Gains and Losses, to determine any capital gain or loss.

8. Are there any exceptions to the market discount rules?

There’s a de minimis exception. Market discount is considered to be zero if the market discount is less than 0.25% of the stated redemption price at maturity multiplied by the number of complete years to maturity after you acquire the bond.

9. How does market discount interact with wash sale rules?

The wash sale rules can apply to market discount bonds. If you sell a market discount bond at a loss and purchase a substantially identical bond within 30 days before or after the sale, the loss is disallowed. The disallowed loss is added to the basis of the new bond, affecting the calculation of market discount on the new bond.

10. What happens to market discount if I hold the bond until maturity?

If you hold the market discount bond until maturity, the difference between the face value and your adjusted basis (your purchase price) is treated as ordinary income to the extent of the accrued market discount.

11. Can I amend a prior year tax return to make the election to include market discount currently?

Generally, you cannot amend a prior-year tax return to make the election. The election must be made on the tax return for the year you acquired the market discount bond.

12. Should I consult a tax professional about market discount?

Absolutely. The market discount rules can be complex, and the best tax strategy depends on your individual circumstances. Consulting with a qualified tax professional can help you understand your options and ensure you are properly reporting market discount on your tax return, optimizing your tax outcome.